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A classic out of favour opportunity

John Baron expects to be amply rewarded for his two contrarian purchases
May 1, 2012

At the end of last month's column I promised to explain why The Biotech Growth Trust (BIOG) had been added to the Growth portfolio. Since then, I've also increased both portfolios' exposure to the healthcare sector. The two are related. Healthcare generally presents a classic opportunity: it remains out of favour and yet the outlook continues to improve - helped in part by advances in biotechnology. Sentiment lags fundamentals and I think patient investors will be amply rewarded.

The story

In many cases, the full investment ramifications of the rapid growth in the world's population have yet to be fully appreciated. The healthcare sector is one such example.

The population is set to grow from around 6.7bn to, according to the UN, 9bn by 2050 - a rate of growth unsurpassed in the world's history. What is more, the population is ageing as people live longer. Meanwhile, expectations - influenced by the advances of science and greater affluence - are rising: conditions once seen as beyond hope now demand treatment. This is particularly the case for conditions relating to old age.

But the story doesn't end there. Increasingly affluent and educated societies in the emerging markets will prove lucrative markets. Drug expenditure in China, India and Russia is around $15-$20 per head a year, compared with $800 in the US. Despite herbal remedies being more prevalent in certain emerging economies, the potential is enormous.

It almost doesn't matter how weak the global economy is, or when the eurozone crisis will finally implode, or whether inflation or deflation is the greatest short-term threat. What we do know is that people are going to spend more money on healthcare - a lot more. Investors will attach greater value to certainties in choppy waters.

With such a positive market backdrop, one could have expected the sector to be performing well. The main reason it hasn't, and that investor sentiment is so low, is because of concerns about the patent cliff. New drug development used to be dominated by the big pharma companies. The post war consolidation of drug companies produced a cluster of new drugs. But new drugs now cost a lot more to develop and take more time - on average around seven to eight years. This just leaves 12-13 years before the patent expires and other manufacturers can produce a generic version. No wonder productivity has fallen away during the last decade.

However, the patent cliff is now well understood. AstraZeneca has been the latest to remind everyone of the need to beef up the development pipeline. As investors have been avoiding the sector, earnings and dividends have been growing steadily - as have cash piles. The big drug companies are not standing still. Using their strong balance sheets, they are diversifying into other areas, such as vaccines, and their hunting ground is the biotech/biopharma sector. AstraZeneca is buying out gout specialist Ardea on a 50 per cent premium. Roche took out Genentech. GlaxoSmithKline has approached Human Genome Sciences.

We see every day the advances of technology in our iPads and smartphones. We are less conscious of the advances of technology in our laboratories. Yet these have been remarkable and powerful. So much so, some are predicting that in the next decade all cancers will be curable, death from all sorts of diseases will fall away rapidly, and a multitude of conditions will be controllable or curable. Life expectancy will rise to over 100.

The DNA discoveries by Watson and Crick in 1953 and the sequencing of the human genome have opened up a world of possibilities. The combination of computers, technology and biology will continue to drive medicine forward. The falling cost of computing in particular has benefited the smaller biotech companies, which have proven more nimble in their discoveries compared with their larger pharma brethren. More than 50 per cent of new approvals now emanate from this sector despite the large pharma research and development budgets.

No wonder this is causing a strategic rethink in many blue-chip boardrooms. A fusion of idle cash piles and the right biotech companies could benefit both sectors and, more importantly, mankind.